The Economic Crisis

by Krishna on October 19, 2008

These are uncertain economic times. Worldwide, governments are trying to prevent another depression. Yet, just a year ago, the stock markets had hit record highs and everything was looking great. That is why it is called a bubble – when it bursts, there is no gradual decrease. It just goes pop!

Warren Buffet says, “A simple rule dictates my buying; Be fearful when others are greedy, and be greedy when others are fearful.” When the markets are ruled by greed, when everyone thinks that they may make an easy profit, be very scared. There is nothing worse than being the greatest and last fool in a market.

Let me state some obvious facts. To make money, you must sell something at a cost higher than it took for you to create or buy it. If you buy a product and wish to sell it at a higher price, there must be some additional value that would attract sellers. For example, a carpenter converts wood into chairs, a supermarket provides the convenience of retail, a farmer converts barren land into a corn field. Without this, sellers could directly buy from the source, eliminating you the middleman, which is exactly what the Internet has done for many professions.

But the selling price can also increase without value-add whenever there is an increased demand that is disproportionate to the supply of the product. Disruptions of food supplies cause food prices to increase. More fuel usage results in higher gas prices. Under normal conditions, they should not be widespread or long-lasting because of two factors.

When a product experiences high inflation, suppliers increase production to take advantage of the high prices. Secondly, customers reduce demand by using substitutes wherever possible. For example, when oil prices increase heavily, there is a greater incentive for oil producers to drill more. Customers drive less. Alternative energy sources become comparatively cheaper, thus bringing down the price of oil. Technological innovations also bring down prices. There is a delay between the price increase and the changes in supply and demand, but it eventually happens.

But certain conditions can upset this re-balancing. Monopolies or illegal trusts can indulge in some price-fixing, though not as much as you would expect because of the elasticity of prices. Government actions to regulate prices and supply can have a disastrous effect on prices by creating an underground black economy and public shortages. Breakdown of law and order (such as in Zimbabwe) can lead to hyperinflation (11 million % for Zimbabwe in 2008).

The period leading to the current crisis witnessed the inflation of home prices and the crisis was caused by the re-balancing of prices. Consider this: The prices of houses increased across the nation and in other countries. But there was no corresponding intrinsic increase in the value of the houses themselves. It was not that all houses suddenly had massive renovations and that increased their value. The prices of both old houses as well as new houses increased. While there were some regional disparities, there was significant upward movement everywhere, doubling on an average in a few short years.

During the same period, the real median household income in the United States did not increase. What that means is that the ability (based on earnings) of the average person to pay for a house did not increase. But demand increased. Where did the money come from? One set of people found that by taking advantage of lower interest rates (and refinancing their existing mortgages), they could save more and thus afford more house – essentially returning to the same level of debt servicing.

But this demand pushed up prices and created a few dangerous trends. First, rising house prices resulted in less risk for home mortgages because fewer people would default because of the possibility of selling the house for a greater profit. This lead to banks financing increasingly risky mortgages supported by the flimsy proposition of house prices going up forever. Second, the trend invited speculators to enter the market to buy and flip houses for profit, again contributing to a supply crunch. Third, non-home-owners jumped into the market to avoid being priced out of the market and perhaps also not to be left out of the profit game. A vicious circle of events had started.

In the meantime, other events that would reduce prices started, but it would take time for their effects to be visible. Home builders increased the pace of building new homes to take advantage of house prices. Prices reached a point where they lost all meaning with respect to the average person’s ability to pay those prices. For example, some real estate prices in India are greater than those in the United States, even though the per-capita income in India is several times less. Normal company layoffs, tax increases, interest rate changes or even foreign exchange rate changes (which affect income) suddenly had a pernicious and cascading effect on mortgage repayments, consumer demand and home prices.

It is easy to recognize a bubble. It is very difficult to stop one or not to lose money in one. Politicians, for all their finger-pointing, cannot stop a bubble. A bubble means good times with massive amounts of money flowing through the system. It means greater employment and a satisfied electorate. To reduce the effects of the bubble, politicians have to reduce liquidity and discourage growth through higher unpopular taxes or interest rates. Such actions can get in the way of re-elections.

It would have been easy if one could identify bubbles before they actually became bubbles. But a bubble usually starts small and you recognize the trend at the same time a million speculators also notice it and jump into the market with their huge assets. There is a choice between bursting the bubble now (when the pain will be less) or later (when it will wreck the rest of the economy). There are few politicians or regulators willing to make such choices.

Any action taken to slow down the bubble will have a disproportionate impact on lower-income families. For example, by tightening lending regulations, low-income families have to wait longer for home ownership. In the long run, this is a good thing because it saves them from financial disaster, because they are the ones who usually buy at the peak. But this can be a political minefield to navigate.

With regard to losing money, the real estate market has certain characteristics that make it a greater losing proposition than the stock market. When it comes to stocks, you could quit the market after making a packet and then parking the money in risk-free investments. But what does a home-owner do with a house? Even if they manage to sell it for a huge profit, they need a place to live. Since other houses have also increased in prices, they will pay more for a bigger house or the same for a similar house – in both cases, eliminating the profit or more when the downturn hits. Or they could get a smaller house (lower standard of living) – which is generally not a palatable social choice.

When the market crashes, profits of all home owners who sold their houses to move into other (similar or larger) houses are wiped out. The only people who benefit are non-home-owners who bought houses at the start of the housing boom and then sold them sometime before the crash. And those who never had money to participate in the market escape, except to the extent of any effects of the crumbling economy.

What this all goes to demonstrate is that there is no easy money. Statistically, there will be some market players who manage to make millions. But for the great majority of people, big booms and bubbles are massive destroyers of wealth. They seem like great times, but they are illusions that lead to painful times. Market growth should be the result of real, tangible improvements in economic products, not speculation.